It’s a bad day in the stock market, with the Dow down more than 3%. But “early March levels”? No. In early March, the Dow was a good thousand points lower than it is now, and the XLF index of financial stocks, which is trading at just over $10 today, was somewhere below $7. So let’s keep things in perspective, here: we’ve had a big run-up in stocks over the past few weeks, and it’s only natural that they will pull back occasionally.
The Financial Select Sector SPDR Fund, an exchange-traded fund tracking banks, brokerages and insurers, fell to $10.62 from $10.75 in six minutes after FlyOnTheWall.com cited Turner’s blog post at 8:14 a.m. in New York. At 8:30 a.m., FlyOnTheWall advised readers to disregard the earlier story.
What Bloomberg doesn’t say is that the fund in question wasn’t trading between 8:14am and 8:20am: the New York markets are closed then, and weren’t going to open for more than an hour. Pre-market trading is always thin and volatile, and prices can move for any or no reason. Besides, when markets did open, an hour after the news emerged that the blog entry was bullshit, XLF had fallen even further, to $10.59, and it’s been tumbling for most of the rest of the day as well. So it’s a bit much to ascribe any move to this one story, especially when, as Ryan Avent points out, the author of the blog claims to have found stress-test results for HSBC, a bank which isn’t even being tested.
What we’re seeing here is the result of a very common bias: if a stock or an index moves, every journalist’s first instinct is to look for some kind of news which might have moved it. If there’s no obvious news story which might be responsible, a lot of journalists will then start citing non-obvious news stories instead, or even news stories which, by rights, should have moved the market in the opposite direction.
The fact is, however, that especially in these days of extremely high volatility, most stock moves don’t have a reason, especially not a news-based one, and that it’s profoundly silly to look for one — nearly as silly as it is to confuse a one-day fall in indices with a return to multi-decade real lows.
And the lesson of all this? Don’t believe what you read on blogs — but don’t believe what you read in more mainstream journalistic outlets, either. They’re all prone to hyperbole, and the best thing you can do most of the time is simply ignore all of it, and go for a nice walk instead.
Liberia, with the aid of the World Bank, has been negotiating with vulture funds holding $1.2 billion of its debt. You know what vulture funds are, right? They’re evil hedge-fund types who buy up debt at pennies on the dollar, and then sue for repayment in full, with interest and penalties and everything.
Just look at the deal they drove in this case! Liberia, one of the poorest countries in the world, is going to have to pay them, er, nothing at all. The World Bank is kicking in $19 million, a few rich countries are matching that sum, and the vultures are walking away with a not-very-princely-at-all $38 million, or just 3 cents on the dollar. Which probably barely covers their legal fees, let alone the amount they paid for the debt in the first place.
Meanwhile, Ecuador has come out with its own offer to bondholders: 30 cents on the dollar, which is either a “minimum price” (Bloomberg) or else just a starting price which the finance minister expects to fall in a “modified Dutch auction” (Reuters). Dow Jones says it’s a modified Dutch auction with a minimum price of 30 cents on the dollar; in any case, what’s clear is that no one is going to pay much attention to the technicalities until the current government is re-elected next week and all the electoral noise is in the past.
There are many more questions than answers right now on the Ecuador front. For instance, if the bondholders do accept the offer, where will the money come from? How will the auction work? What’s the minimum number of bondholder acceptances needed for the offer to go ahead? If the offer fails, will the Ecuadoreans continue making the coupon payments on their 2015 bonds in full? And since the secondary-market price of the defaulted bonds seems to refuse to fall below the 30-cent level, why would anybody take the government’s offer rather than just sell in the secondary market?
But still, the Liberian precedent will be sobering for anybody thinking about a vulture-like holdout strategy. Sometimes, holding out can pay handsomely: after the last distressed Ecuadorean bond exchange, the small number of holdouts was paid off in full. But as the Liberian example shows, it’s a very high-risk gamble, and it can end up in utter failure.
Dan Gross’s e-book on the financial crisis is now out in paperback, just a couple of months after its release. (By contrast, his last hardback book still isn’t available in paperback, a good two years after it came out.) Bob Thompson gives the backstory in the Washington Post: how Dumb Money was commissioned as an e-book, and how come it came out in print so quickly. I asked Dan a few more questions as a followup, via email.
Felix Salmon: I see the paperback is being published by Free Press, which also published the e-book. Did they get an option to do the paper-and-ink version when they acquired the e-book rights?
Dan Gross: Yes, I think so. But the intent, on their end, at the beginning, was to see what would happen if they did this as an e-book exclusive.
FS: Bob Thompson says that “Success for an e-book exclusive, at least for now, means doing well enough that your publisher decides to sell physical books.” Would you agree? On a purely financial level, are you going to make more money from the paperback than you did from the e-book?
DG: No, I don’t necessarily agree with that. For both publishers and authors, there are lots of ways of defining success for a book — whether it makes money for the publisher, whether it makes money for the author (i.e. generates enough royalties to pay back the advance and then some), whether it establishes the author as an expert on a certain topic that can be monetized in other ways (speaking, consulting, new business), whether it makes an impact on the debate, whether it generates positive buzz for the publisher and author. To a degree, in many instances, the number of copies sold at Barnes & Noble is almost secondary to how I regard the success of any book I do. From my perspective, even if it hadn’t come out in paperback, I would have regarded Dumb Money as a sucess. It’s too soon to answer the money question, since all the royalties go into a single pot. Also, to a degree, everybody who has been writing books in the last few years *has* been doing e-books. Many books are offered in Audio form (delivered digitally) and for devices like the Kindle and Sony Reader.
FS: Other than the length, were there any differences between writing an e-book and writing a normal book? You’ve been writing for Slate for many years, did you want to put in lots of links? Or have e-books not reached that point yet? Insofar as there’s a difference between how you write for Slate and how you wrote when you were working on Pop!, where did this project lie on that spectrum?
DG: As far as writing the book, no big difference — aside from the fact that you don’t have to do an index for e-books. And, yes, I did want to put in a lot of links. A lot of the data and material was taken from my Slate columns over the years, and there are times when you think it would be nice to just linke to a table of, say, subprime mortgage origination numbers, or a chart of Toll Brothers’ stock, rather than spelling it out. You can convey a lot more information in a less boring manner with a link. But I don’t think e-books (at least not the format I was doing) are set up for links like that. That said, I do write a little differently online than when I do when I write in print — whether it’s Slate vs. Newsweek or an e-book vs. a hardcover. It’s not that you use less rigor — if anything, your need to get your numbers, facts, and quotes 100% correct is greater online than in print since so many knowledgeable people can pick it apart so easily. But rather you design your writing process for speed and immediacy, you develop a tendency to let go easier, you worry less about word count, and maybe a little less about rounding out chapters with cute endings. More declarative, less discursive.
FS: Do you know of any reviewers who read (or even received) the e-book, as opposed to the print galleys that we financial-journalism types were sent when the e-book first came out?
DG: This is one of the interesting tensions. The publisher printed up galleys when the manuscript was done, and those were the only hard copies anticipated at first. Why? Because the reviewing community still likes to see hard copies. Speaking as someone who reviews book, I sympathize. I find it easier to read longer works in paper than online, and I like to mark-up, underline, fold down corners of pages, and jot notes in the margin. We were also reluctant to send around a PDF of the whole manuscript because of concerns about leakage. Obviously, somebody can take a galley and scan it, and then post the whole thing online. But that doesn’t seem to happen too often. You could imagine, however, the PDF of a book making it’s away online with relative ease.
FS: Have you ever read an e-book? Have you ever reviewed one?
DG: I haven’t reviewed any. I read my own book on the iPhone, and I have read books in PDF form, which I suppose is a form of an electronic book.
FS: Have you edited or changed the e-book in any way for the paperback version? Insofar as you have, have those changes also been made to the e-book version? How easy is it to edit the e-book now that it has already been released?
DG: The paperback is basically the same as the e-book. In theory, it would have been nice to make some changes, especially to the conclusion and to bring it closer to the present. But you’re still working against the old publishing clock if you do that. It takes several weeks to get the book manufactured, get it into the distribution chain, and onto the stores of bookshelves. So any tinkering would have delayed that process. As it was, about six weeks passed between the time it was available for sale as an e-book and the time it was available as a paperback. INot knowing much about the technical side of things, I would imagine it would be relatively easy to edit the e-book
FS: Would you do it again?
Paul Krugman and James Kwak are unhappy with the way in which the government is proposing debt-for-equity conversions as a way of recapitalizing the banks — mainly because they don’t consider the preferred stock bought initially under the TARP program to be debt in the first place, and if you look at it as equity, it’s true that no one benefits much from an equity-for-equity conversion.
I’m slightly more constructive, because I never really considered preferred stock to be equity in the first place. It looks like a bond, paying a fixed coupon, and it serves to increase the leverage of common shareholders, just like debt does. If the government converts it into pure equity, then that leverage goes down, which is a good thing, and the bank in question no longer has to make those coupon payments.
More to the point, if a bank ever defaulted on its preferred coupons, that’s game over right there: the FDIC would never stand for such a thing, and would take it over. In that sense, preferred stock can’t really be considered risk capital, which is the intuitive definition of equity. Common stock, by contrast, is risk capital — and if the government’s main aim here is to get the banks lending again (and according to the WSJ today, they’re not), then you want the government capital to be as junior as possible.
Indeed, this is quite close to the general plan I’ve been sketching out for some months now: massively dilute the common shareholders, impose a haircut on the preferred, and leave the senior unsecured largely untouched. The only alternative would be to inject yet more hundreds of billions of taxpayer dollars into the banking system, without any real indication that the money would be put to good use. Congress doesn’t want that, and neither do I.
Gabe Sherman has put together an astonishing concatenation of moans and whines from New York’s monied classes, and it makes for enlightening reading. You thought that New Yorkers were all liberal Obamaphiles? Well, they were — until their seven-figure bonuses started coming under attack.
The most interesting part of the piece, to me, is the way in which these professionals consider what they do to be much more valuable than what other people do:
“No offense to Middle America, but if someone went to Columbia or Wharton, [even if] their company is a fumbling, mismanaged bank, why should they all of a sudden be paid the same as the guy down the block who delivers restaurant supplies for Sysco out of a huge, shiny truck?” e-mails an irate Citigroup executive to a colleague.
As Sherman says, bankers are the last Americans to Get It: they don’t think that the excesses of Wall Street were responsible for wealth destruction rather than wealth creation, and they still think that a degree from Wharton is, in and of itself, a Good Thing. One financier essentially tells Sherman that the going rate for any job which involves being woken up in the middle of the night should be roughly $2 million a year — which is not the kind of attitude guaranteed to make you friends among, say, the farming community.
Most people outside Wall Street have come to the conclusion that excess pay was a direct cause of the current meltdown, but the highly-paid symbolic analysts at our biggest investment banks somehow have a massive blind spot when it comes to that fact. Just check out the cognitive dissonance here:
“One of my relatives is a doctor, we’re both well-educated, hardworking people. And he certainly didn’t make the amount of money I made,” a former Bear Stearns senior managing director tells me. “I would be the first person to tell you his value to society, to humanity, is far greater than anything that went on in the Bear Stearns building.”
That said, he continues, “We’re in a hypercapitalistic society. No one complains when Julia Roberts pulls down $25 million per movie or A-Rod has a $300 million guarantee… you can pick on Wall Street all you want, I don’t think it’s fair. It’s fair to say you ran your companies into the ground, your risk management is flawed—that is perfectly legitimate. You can lay criticism on GM or others. But I don’t think it’s fair to say Wall Street is paid too much.”
Of course Wall Street’s compensation structures were doubly responsible for its flawed risk management. Firstly, they created excess risks: they encouraged investment bankers to put on what I call the Rubin Trade, where you make massive bets that something with a 95% probability of happening will indeed happen. And secondly, they contributed to the marginalization of the risk-management function in investment banks: since risk managers were paid so much less than star traders and top management, they tended to get overruled a lot, and in any case be discouraged from spending too much time looking at the really important big-picture views of systemic risk.
The bankers’ belief in their own ability to make money is so unshakeable that you still hear things like this:
The most aggressive employees, those who took the greatest risks, thought of themselves less as members of a firm and more as independent contractors entitled to their share of the profits. In this system, institutions tended to be hostage to their best employees. “The feeling is, if people don’t get compensated adequately, they’re going to go out and do this on their own,” says Alan Patricof, who founded the private-equity firm Apax Partners.
Well, I hope they do. So long as they’re not gambling away trillions of dollars of other people’s money at systemically-important institutions, they’re welcome to do as they like. But if they do work at a systemically-important institution — one where the government and the economy as a whole will pay dearly if they blow up — then they shouldn’t be paid the kind of money which encourages putting on outsize risks. And the sooner they wake up to that fact, the better.
Edmund Andrews has the news that the Obama administration seems to have settled on its preferred method of recapitalizing banks which have failed its stress test: it’s going to take the TARP money that it’s already lent them, and convert it into equity. That makes perfect sense to me: it avoids the government having to ask Congress for extra funds, and it implies that banks will be nationalized to precisely the degree the government considers them to need its own recapitalization.
There will of course be one extra step in between. No bank can fail a stress test; instead, a preliminary stress test will reveal which banks require recapitalization. Then the banks will be given the opportunity to recapitalize themselves privately. If they can’t or won’t do that, then the government will step in with its debt-for-equity conversions.
And as far as that second step is concerned, it’s actually possible that there’s money out there now for banks willing to tap it. Richard Barley reports today on the revitalization of the convertible-bond sector, which is where most private-sector bank capital came from in the months immediately prior to the market shutting down completely:
Nomura said that before September 2008, 73% of its European trading in convertibles was with arbitrage-driven hedge funds. Now, 68% is with investors who buy the bonds outright. The global trend is similar, the bank said.
That change, combined with an investor focus on companies’ ability to refinance debt, means share prices are actually going up when convertibles are announced.
Steelmaker ArcelorMittal’s shares rose 7.6% when it sold a €1.1 billion ($1.45 billion) deal in March that was then increased to €1.25 billion…
Convertible investors are happy as prices are showing strong gains right after issuance, while traditional stock investors are getting a fillip as well. And investment banks are tapping into a fresh seam of fees.
Now banks, of course, aren’t steelmakers, and the fact that ArcelorMittal can successfully get a convertible away in Europe does not remotely mean that Bank of America, say, could manage to do one in the US. But BofA’s results this morning were solid, and bank stocks in general have been performing so well in recent weeks that there’s a reasonably large constituency of potential investors who might be interested in buying up some convertible bonds at attractive prices.
I’m just not completely convinced that the real-money market for convertible debt is as strong as Barley might like to think. If the hedge-fund bid disappears entirely, then of course the real-money investors will make up a higher proportion of the market. But that just means the market is a fraction of its former size. And what’s not obvious is that there are new real-money convertible-bond investors — people who might have been plain-vanilla equity investors in the past, but who now prefer the downside protection of a convert.
The fact is that convertible bonds are very scary things to most buy-siders: valuing them involves some pretty sophisticated option math, which is one reason why historically such bonds have been sold overwhelmingly to arbitrageurs. At the very least anybody buying a convertible bond should be able to work out the market price of trying to replicate it in the secondary market with a combination of debt and equity options, and should therefore be comfortable in the world of equity derivatives.
Are such people numerous enough to help recapitalize the entire US banking system? I’m sure that Treasury hopes so: the last thing it wants is to become the single largest shareholder in most of America’s biggest banks. But given how burned the last round of financial-institution convertible bond buyers ended up, I’m not holding my breath for a new set of investors to come galloping over the horizon on their white steeds, ready to save the government from being forced to implement its contingency plans.
One of the most exciting parts of moving to Reuters is the fact that we’re putting together what promises to be a very bloggy and truly international economics and finance website. The bloggy bit I’m enthusiastic about — but the international bit is actually quite a serious obstacle, because the finance and economics blogosphere simply hasn’t taken off overseas in the same way that it has in the US.
But at least we’re looking to hire mainly in London rather than in Frankfurt. While English econobloggers are far fewer than their US counterparts, at least the Brits tend to have a vague idea what a blog is; some of them are even positive about the idea. It’s not unthinkable that the UK will have a vibrant blogosphere in the future. In Germany, by contrast, I simply can’t imagine such a thing ever taking off.
Why not? Here are are ten possible reasons.
- The blogosphere is fundamentally egalitarian, to the point at which the young and even the completely anonymous can become A-listers. At the same time, highly respected professors and experts often find themselves ignored, perhaps because they hedge themselves too much or are simply too boring to pay attention to. Germany, by contrast, is fundamentally hierarchical.
- In Germany, qualifications matter, a lot. People spend decades amassing various qualifications, and when you have a certain qualification, you make sure everybody knows it. If you don’t have a piece of paper qualifying you to opine on a certain subject, then you have no grounds for inflicting you opinions on everybody else. Similarly, readers want to be reassured of a writer’s qualifications before paying attention to what that writer is saying. The blogosphere is the opposite: opinions are judged on their own merit, rather than on the basis of the qualifications of the person holding them.
- In the US, where the econoblogosphere is at its liveliest, we’ve now reached the point at which a majority of policymakers, at least on the economics side of things, are paying attention to what the blogosphere is saying. Take someone as self-assured and important as Larry Summers, the most important economist in the Obama administration. He’s a big reader of blogs, and not just those by big-name technocrats: he also reads blogs written by people who would never normally have any voice in the government. That kind of respect for the voice of the people is fundamentally American, and is not particularly German.
- The skills needed to be a great blogger are very different from the skills needed to be a great economist or banker. In career-minded Germany, at the margin one will tend to cultivate important professional skills rather than much less important blogging skills.
- In the blogosphere, it’s of paramount importance that you are wrong, at least occasionally: if you’re never wrong, you’re never interesting. It’s one of the biggest obstacles to entering the blogosphere in any country: people are scared of writing something which makes them seem stupid. That fear might be particularly strong in Germany, where public pronouncements tend to be carefully thought through. If you’re writing about something you don’t know a lot about, you’ll be afraid to have missed something obvious; if you’re writing about something you do know a lot about, then you have a lot of reputation to lose if you make a mistake.
- The German way of doing things tends to be methodical and systematic and comprehensive, while the bloggy way of doing things tends to be scattershot and ad hoc and hard to pin down.
- Bloggers tend to situate themselves on the outside looking in; they take pride in their outsider status, and often picture themselves as speaking truth to power. In Germany, declaring yourself to be an outsider in that way is not a route to respectability, and respectability is something that a very large number of Germans aspire to.
- The US econoblogosphere is driven by tenured economics professors, who love nothing more than to share ideas and debate with each other online. Germany doesn’t have nearly as many economics departments, and it certainly doesn’t have hotbeds of blogging like George Mason University, which can then spread to the rest of academia.
- Germans aren’t going to work without being paid to do so, and blogging seems suspiciously like work. Insofar as Americans do make money from blogging, it’s generally in an indirect way, through the extra fame and publicity that a blog brings. Since a German blog is very unlikely to bring extra fame or publicity, there’s not much reason to cultivate one.
- Germans take their vacations extremely seriously, and it’s hard to take a vacation from blogging.
Now all this said, I’ve actually met a significant number of Germans who are very enthusiastic about blogging and who think it would be great if a German blogosphere were to take off. Even they, however, aren’t likely to start blogging themselves unless and until a significant number of other bloggers emerge. So you have a first-mover problem which is very hard to overcome. Add that to the language issues — writing in English and writing in German both have their downsides — and my feeling is that the probability of an interesting econoblogosphere emerging in Germany is very close to zero.
Commenter VM asks whether reduced incentives for bondholders to keep a company out of bankruptcy aren’t “a fairly horrible side effect” of the credit default swap market. Megan McArdle is thinking along similar lines, and her blog entry elicited a rather unconvincing response from Charles Davi.
To Charles’s point, no one is accusing cunning bondholders of finding “a serious loophole”, or “a nice way to make some fast cash”, or perpetrating a “restructuring-sabotage-strategy”. The problem is a bit more subtle than that, and is simply that bondholders who have bought CDS protection have much less incentive to participate in restructuring negotiations.
Let’s say that I buy $1 million of bonds. In order to protect my downside, I buy $600,000 of credit protection: if the issuer goes bust, I get $600,000, and a healthy 60% recovery value. I don’t want the issuer to go bust — I’d much rather the bonds continued to perform, and to be worth $1 million. But at least I can’t lose more than $400,000 in the event of default.
The issuer then gets into serious difficulties, and the bonds start trading at 25 cents on the dollar: my $1 million of bonds are now worth just $250,000 on the open market. The distressed issuer then seeks to avoid bankruptcy by entering into negotiations with its bondholders. “If we default and are forced into bankruptcy,” they say, “then bondholders will end up collecting no more than 20 cents on the dollar in a liquidation. But if you agree to a restructuring which keeps us out of the bankrupcy court, we can get you a good 45 cents on the dollar in value.”
Normally, bondholders would be well disposed to such an offer. But in this case, I might think twice. If the restructuring doesn’t count as an event of default for the purposes of the CDS contract, then I might end up with just 45 cents on the dollar — $450,000 — if I agree to the company’s plan. If I just let it go bust, on the other hand, I get $600,000.* And so I have an incentive to opt for the more economically-destructive option.
Now there’s one big problem with this story: any restructuring as drastic as the one I described would count as an event of default — so owners of credit protection would get paid out either way.
But the fact is that whenever bondholders have bought credit protection, someone else — the protection seller — is in the position of caring deeply whether or not a restructuring goes through. But at the same time, that person can only cheer from the sidelines, and has no actual role in the bondholder negotiations, since they’re not a bondholder. Meanwhile, the bondholder doesn’t care nearly as much about the outcome of the negotiations as the issuer would like, since a lot of his exposure is hedged either way.
All of which leads Megan to propose that “swap contracts should allow the issuers to get involved in these negotiations, the way insurance companies sit at the table during lawsuits”. This is a bad idea, since there’s no limit to the amount of credit protection which can be written on any given issuer. A company thinks its dealing with a known quantity of bondholders, and then suddenly sits down at the restructuring-negotiation table to find ten times as many protection sellers? No one wants that.
And Charles Davi’s idea that companies could somehow constrain their creditors from buying credit protection is even sillier — and probably illegal. The whole point of issuing bonds is that they’re tradable, fungible, and anonymously held. You can’t covenant up bondholders in the same way you can with bank lenders.
The real solution here is to minimize the economic costs of bankruptcy. If the outcome of bankruptcy proceedings is that creditors end up with just as much value as they would have gotten from a restructuring, then there’s really no problem either way. When it’s done well, bankruptcy is little more than a change of ownership: shareholders get wiped out or diluted, and the old creditors become the new owners. The company itself doesn’t need to change much at all.
But there are certainly times when a constructive bond restructuring is going to create much more value than a drawn-out bankruptcy proceeding. And the existence of the CDS market does make such restructurings more difficult — just as the fact that mortgages have been sliced and securitized makes mortgage modifications more difficult.
Restructuring bonds outside bankruptcy is never easy — and that in fact is one reason why the bond market is normally so healthy: both issuers and investors know that companies can’t easily go back on their promise to pay what they owe. That helps to bring down the cost of funding for all companies in the bond market. But in times like these, when restructurings sadly become necessary on a large scale, having a lot of bonded debt is a problem. And when that bonded debt has been hedged in the CDS market, the problem becomes bigger still.
*Update: Hemant, in the comments, points out that I actually get $700,000, not $600,000: I get $600,000 from the hedged portion, and also another $100,000 (25% of $400,000) from the unhedged portion.
Obama’s Economics Speech: POTUS is by far the best communicator of economic concepts in the administration.
Why credit swaps encourage bankruptcy: It’s easier to buy protection than it is to negotiate.
More bad news on the recovery: Two more reasons why things are going to get worse before they get worse.
The Failure of #amazonfail: Emotion will always trump rationality.
Why do people like streetcars so much? A great discussion in the comments. Count me in among the streetcar-lovers, too.
A Heartbreaking Work of Staggering Hubris: I would so buy The Copula Identity in a heartbeat.